Question 3 Demand elasticity is a measure of how much the quantity demanded will change if another factor changes.

In proper words, it is the relative response of one variable to changes in another variable. The three main types of elasticity but only two will be discussed and they as follows: A. Income elasticity of demand (YED) Income elasticity of demand (Y D! measures the relationship between a change in quantity demanded for good " and a change in real income. The formula for calculating income elasticity of demand: # change in quantity demanded change in income The degree to which the quantity demanded for good changes in response to a change in income depends on whether the good is a necessity or a lu$ury as describe below: i. Normal Goods

%ormal goods have a positive income elasticity of demand (between & and '(! so as income rises more is demanded at each price level. ) good e$ample of a normal good is the type of clothes we buy. If a consumer has low income, he will buy ine$pensive clothes. *owever when the consumer starts to earn more money he is li+ely to buy more e$pensive and branded clothes. In other words, the consumption increases as the income increases. ii. Luxury Goods

,u$uries are items we can manage to do without during periods of below average and have an income elasticity of demand > (. -hen incomes are rising strongly and consumers can ma+e big spending, so the demand for lu$ury goods will grow. .onversely in a recession, customers will minimi/e their spending and rebuild savings.

)n e$ample of a lu$ury good is a round of golf. -hen income is low, we will not play golf. *owever, once income rises the consumer can afford to play golf. In other words, the increase in playing golf will be (&& percent while the increase in income may have only been (0 percent.

iii.

Inferior Goods

) type of good for which demand declines as the level of income or real 1D2 in the economy increases. Inferior goods have a negative income elasticity of demand. In a recession the demand for inferior products might actually grow .Transportation provides a good e$ample of inferior goods. -hen income is low, consumers prefer to ride the bus. 3ut as income increases, people stop riding the bus and start buying cars. 3us riding declines as income increases. ,et4s ta+e an e$ample to illustrate normal goods and inferior goods. There are two commodities in the economy5 flour and consumers are consuming both. 2resently both commodities face a downward sloping graph, that is the higher the price the lesser will be the demand and vice versa. If the income of consumer rises, then he would be more inclined towards wheat flour which is more costly than 6owar flour. Therefore, he will switch his flour demand from 6owar to wheat. *ence 6owar, whose demand has fallen due to an increase in income, is the inferior good and wheat is the normal good as shown below:

It should be noted that Y D is used by businesses for various purposes as shown below:

!. "ales forecastin# ) firm can forecast the impact of a change in income on sales volume and sales revenue. 7or e$ample, a car manufacturer has calculated that Y D with respect to its lu$ury car is ('! 8.9, and it has also underta+en research to discover that consumer incomes will rise by :; ne$t year. It can now predict the impact of this change and increase production.

$. %ricin# &olicy <nowing Y D helps the firm decide whether to raise or lower price following a change in consumer incomes. If incomes are falling and Y D is positive, a reduction in price might help compensate for the reduction in demand.

3. Di'ersification 7irms can diversify and offer a range of goods with different Y Ds to spread the ris+s associated with changes in the level of national income. 7or e$ample, a car manufacturer may produce cars with a range of Y D values, so that sales are stabili/ed as the economy grows and declines. (. Economic situations <nowing the Y D of a product may help a firm respond to changing economic situations and help the firm to plan ahead. If a firm is producing inferior goods, demand will increase during periods of recessions and economic downturns. Therefore, at the present moment a company may be advised to advertise its value products. This may attract customers trying to survive on a tight budget. If the economy was booming, then firms should try to promote lu$ury items .These good will sell better as incomes are rising. *owever Y D is not only used by businesses. 1overnment uses Y D to solve several economic issues and helps to earn more revenue. Thus +nowing the income elasticity of demand is important for government for the following reasons:

!. )onsum&tion The income elasticity also shows us another important impact. It shows the consumption and enables the 1overnment to ma+e planning accordingly. The increasing income leads to rise in consumption. The best e$ample in this case is the demand for automobiles which has been growing rapidly in the past few years. This will show the usage of fuel as well as of the road networ+s. This will help the government to underta+e infrastructure programs in the country. The income elasticity shows which products are moving up with increased incomes and which are left behind by the consumers. $. *ax on "a'in#s The Y D helps government to +now whether to increase ta$ the savings of consumers or not. 7or e$ample, if income is rising at high level, consumers will ma+e savings. 1overnment can therefore increase the ta$ on the savings so as to earn more revenue. .onsumers will stop saving as money loses value. 3. +oney "u&&ly The Y D acts as a measure to solve the problem of too much money in circulation. 7or e$ample, if there is too much money in circulation, this will cause inflation. Therefore government can reduce the ta$ on savings and which shall in turn encourage customers to ma+e savings and reduce circulation of money.

,. %rice Elasticity of Demand (%ED) )ccording to the law of demand, the lower the price the more products are bought. 2rice elasticity of demand measures the responsiveness of demand to changes in price for a particular good. If the price elasticity of demand is equal to &, demand is perfectly inelastic. =alues between /ero and one indicate that demand is inelastic. -hen price elasticity of demand equals one, demand is unit elastic. 7inally, if the value is greater than one, demand is perfectly elastic. This is illustrated in the diagram below:

The following formula can be used to measure e$actly how responsive demand is to a given price change:

The Algebraic terms means:

-hen you reduce the price of most items, people will buy more of them. 7or e$ample, when supermar+ets ma+e special offers with reduced prices, they e$pect a sharp increase in corresponding sales. *owever, businesses need to have more precise information than this .They need to have a clear measure of how the quantity demanded will change as a result of a price change. 7or e$ample, suppose that a supermar+et reduces the price of a pac+aged ca+e from >s(.&& to 9& cents. ?ay sales per wee+ then rise from 0&& to @&&. 2ercentage change in sales # A&;, and percentage change in price # :&;.?o 2 D # A&;B:&; # :.&.This tells us that demand for ca+es is price elastic.

,et4s ta+e another e$ample, now suppose that the supermar+et increases the price of washing up liquid from >s(.&& to >s(.:&. -ee+ly sales drop only from (,&&& to C&& bottles. 2ercentage change in sales # (&; and percentage change in price # :&;.?o 2 D # (&;B:&; # &.0 .This tells us that the demand for washing up liquid is price inelastic.

1enerally, the more the customer has good substitutes available, the more demand will be price elastic and when there are few alternatives, demand is inelastic. There are several reasons why firms gather information about the 2 D of its products and they are as follows:

!. "ales forecastin# <nowledge of 2 D can help the firm forecast its sales and set its price. The firm can forecast the impact of a change in price on its sales volume, and sales revenue 7or e$ample, if 2 D for a product is (D! :, a (&; reduction in price (say, from E(& to EC! will lead to a :&; increase in sales (say from (&&& to (:&&!. In this case, revenue will rise from E(&,&&& to E(&,9&&.

$. %ricin# &olicy -hile fi$ing the price of this product, business has to consider the elasticity of demand for the product. The firm should consider whether a lowering of price will stimulate demand for the product and if so to what e$tent and whether his profits will also increase a result .If the increase in his sales is more than proportionate to the reduction in price, his total revenue will increase and his profits might be larger. Fn the other hand, if increase in demand is less than proportionate to fall in price, his total revenue we will fall and his profits would be certainly less. 3. "-iftin# of tax .urden To what e$tent a producer can shift the burden of indirect ta$ to the buyers by increasing price of his product depends upon the degree of elasticity of demand. If the demand is inelastic the larger part of the indirect ta$ can be shifted upon buyers by increasing price. Fn the other hand if the demand is elastic than the burden of ta$ will be more on the producer. (. %rice discrimination 2rice discrimination refers to the act of selling the technically same products at different prices to different section of consumers or in different in subDmar+ets. Those consumers whose demand is inelastic can be charged a higher price than those with more elastic demand.

2 D is also used by government for different purposes which enable the latter to ma+e better decisions .3elow are a few purpose why 2 D is used by government:

!. *axation and su.sidy &olicy The government can impose higher ta$es and collect more revenue if the demand for the commodity on which a ta$ is to be levied is inelastic. Fn the other hand, in ease of a commodity with elastic demand, high ta$ rates may fail to bring in the required revenue for the government. 1overnment should provide subsidy on those goods whose demand is elastic. If the demand for hotel rooms is very inelastic, then the government can increase the sales ta$ on hotel rooms without creating a situation where hotels lose business and ta$ revenues fall. 1overnments will not want to raise sales ta$es on items that are very elastic. Therefore, governments need to +now about price elasticity of demand. $. Im&ortance in international trade The concept of elasticity of demand is of crucial importance in many aspects of international trade. The success of the policy of devaluation to correct the adverse balance of payment depends upon the elasticity of demand for e$ports and imports of the country. The policy of devaluation would be beneficial when demand for e$ports and imports is price elastic. ) country will benefit from international trade when: i. It fi$es lower price for e$ports items whose demand is price elastic and high price for those e$ports whose demand is inelastic ii. The demand for imports should be inelastic for a fall in price and inelastic for arise in price. The terms of trade between the two countries also depends upon the elasticity of demand of e$ports and imports of two countries. If the demand is inelastic, the terms of trade will be in favor of the seller country. 3. Effect of use of mac-ines on em&loyment

Frdinarily it is thought that use of machines reduced the demand for labour. Therefore, government often opposes the use of machines fearing unemployment. 3ut this fear is not always true because use of machines may not reduce demand for labour. It depends on the price elasticity of demand for the products. The use of machines may reduce the cost of production and price. If the demand of the product is elastic then the fall in price will increase demand significantly. )s a result of increased demand the production will also increase and more wor+ers will be employed. In such cases concept of elasticity of demand help the government to increase employment.

(. %u.lic utilities
The nationali/ation of public utility services can also be 6ustified with the help of elasticity of demand. Demand for public utilities such as electricity, water supply etc, is generally inelastic in nature. If the operation of such utilities is left in the hand of private individuals, they may e$ploit the consumers by charging high prices. Therefore, in the interest of general public, the government owns and runs such services. The public utility enterprises decide their price policy on the basis of elasticity of demand.

>eal world evidence shows that both income elasticity of demand and price elasticity of demand are equally necessary for businesses and government. They act as a means to ma+e better decisions and earn more revenue.